Terminix Global Holdings Inc (TMX) 2017 Q2 法說會逐字稿

Ladies and gentlemen, thank you for standing by, and welcome to the second quarter 2017 earnings call. (Operator Instructions) As a reminder, this call is being recorded Monday, July 31, 2017.

I would now like to turn the conference over to Mr. Brian Turcotte, Vice President of Investor Relations and Treasurer. Please go ahead, sir.

Thank you, Carlos. Good morning, and thank you for joining our second quarter 2017 earnings conference call. Before I review the agenda and introduce the other speakers, I'd like to remind you that throughout today's call, management may make forward-looking statements to assist you in understanding the company's strategies and operating performance.

As stated on Slide 2, all forward-looking statements are subject to the forward-looking statement legends contained in our public filings with the SEC. These forward-looking statements are not guarantees of performance and are subject to the risk factors contained in our public filings that may cause actual results to vary materially from those contemplated in the forward-looking statements. Information discussed on today's call speaks only as of today, July 31, 2017. The company undertakes no obligation to update any information discussed on today's call.

This morning, ServiceMaster issued a press release filed with the SEC on Form 8-K, highlighting our second quarter 2017 financial results, and we have posted a related presentation, both of which can be found on the Investor Relations section of our website.

We will reference certain non-GAAP financial measures throughout today's call, and we have included definitions of those -- these terms in our press release, which is available on our website at www.servicemaster.com. We have also included a reconciliation of these non-GAAP financial measures to the most comparable GAAP financial measures in our press release and presentation in order to better assist you in understanding our financial performance. All references on the call to EBITDA today are to adjusted EBITDA as defined in our press release.

For those of you that may have missed it, on Wednesday, July 26, we announced the appointment of Nikhil Varty as Chief Executive Officer and as a member of the board effective immediately. We also announced that ServiceMaster intends to separate its American Home Shield business from its Terminix and Franchise Services Group businesses. That announcement was filed with the SEC on Form 8-K and is also available on our website.

Let's turn to the agenda. Joining me on today's call are ServiceMaster's new Chief Executive Officer, Nik Varty, and Chief Financial Officer, Tony DiLucente. For those of you that haven't had a chance to download the investor presentation from our website, I'll walk through the agenda items shown on Slide 3.

Nik will lead off with some opening remarks about his early observations and the new direction at ServiceMaster. Tony will follow and summarize our consolidated second quarter financial results and discuss some of our key business initiatives. He will then review the business unit results, provide more details on our consolidated results and then speak to the updated full year outlook. Nik will then provide summary comments after we take your questions.

I'll now turn the call over to Nik. Nik?

Thanks, Brian. Good morning, and thank you all for joining us today for our second quarter 2017 earnings call. I'm very excited to join the ServiceMaster team and to be part of the new direction for the company.

Although I've been in my role for less than a week, I've already met with a significant portion of ServiceMaster management team and people and spoken with a number of our shareholders. If you read my background, you know I have extensive experience leading large organizations and driving revenue and growth profitably, including some service businesses. It's clear to me from my initial discussions with the board and some of you that we agree that there is a significant opportunity to unlock value at ServiceMaster by sharpening our focus on results and operational excellence. My first few days on the job confirmed my belief in the strong potential of the ServiceMaster brands.

We took the first step in that process last Wednesday when we announced our intention to separate American Home Shield from the Terminix and Franchise Services Group into a separate publicly traded company through a tax-free spin. I'm very supportive of the board's decision to separate the AHS business and believe that is the right and necessary step at this point in time. The separation will better position both companies to focus on their unique business needs and market opportunities and grow according to their own distinct business strategies. We believe it will enable investors to evaluate and invest in each business with greater clarity based on their individual merits and very attractive future growth prospects. We expect the separation to be completed in the third quarter of 2018.

I know that our shareholders and debt holders as well as employees, vendors and partners, have a number of questions regarding this transaction, and we are committed to keeping you informed as this process moves forward. My immediate focus will be on providing leadership and strengthening the execution at Terminix to deliver consistent growth and profitability.

I'd also like to mention that we're on schedule to move the ServiceMaster headquarters to the new downtown Memphis location in the first quarter of 2018. Once again, I'd like to say how excited I am to join ServiceMaster, and I'm looking forward to sharing my vision with you in the coming quarters.

I'll now turn the call over to Tony to review our second quarter results and full year outlook.

Thanks, Nik, and good morning, everyone. Turning to our consolidated results as shown on Slide 5. ServiceMaster produced solid revenue and EBITDA growth in the second quarter. Revenue grew $60 million or 8% compared to the prior year. Our results were primarily driven by organic growth at American Home Shield, where we continue to see strong demand for our products in both the real estate and direct-to-consumer channels coupled with the favorable impact of our acquisitions of OneGuard Home Warranties and Landmark Home Warranties last year.

Terminix delivered nearly 3% organic revenue growth versus prior year, and the Franchise Services Group grew organically by 8%, excluding the impact of the converted Merry Maids branches to franchises.

Adjusted EBITDA for the second quarter increased $7 million or 3% compared to the prior year. The increase in EBITDA was primarily the result of a conversion of higher revenue driven by organic growth and acquisitions at the American Home Shield and royalty fee growth at the Franchise Services Group. The planned strategically investment in field operations, sales force growth and training and higher commissions drove margin compression at Terminix versus the prior year. What's encouraging is that we've begun to see the benefits from these investments, as evidenced by the organic revenue growth this quarter, and firmly believe that we're on a clear path to improve customer retention and organic growth. I'll cover the second quarter performance of Terminix in more detail in a moment.

Our adjusted net income for the second quarter was $93 million, flat versus prior year, and adjusted diluted earnings per share of $0.69 was up over $0.01 versus the prior year. This slight increase in EPS was largely driven by the share repurchases reducing the weighted average common shares outstanding by 2.6 million shares over the past year.

Turning to Slide 6, I'd now like to take a few minutes to discuss some of the key focus areas for 2017 to improve the customer experience and organic growth at Terminix. As the graphic shows, we are significantly upgrading field routing and scheduling. We continue to staff our branches to the optimal levels to provide superior service and maintain those staffing levels while using our new multi-day planning tool, or MDP, to optimize technician capacity. As we mentioned on the first quarter's earnings call in April, the MDP process enables us to improve route efficiency and service by stabilizing our production schedules and improving on-time delivery.

Additionally, Terminix now has deployed our new mobile digital service platform to all branches nationwide. The system allows real-time customer engagement through text messaging, on-my-way notifications and instant post-service feedback to enhance the customer experience and improve service productivity.

Also, the use of the mobile digital platform, combined with optimizing routing and scheduling, helps our technicians effectively meet customer requests and efficiently deliver service at scale. The platform also gives leadership visibility into each and every interaction as they happen, and this ensures successful outcomes that allows us to address the customer needs in real time.

We're also sharpening our focus on product and pricing, where we are developing alternative pest control billing options for our customers as well as piloting optimal pest control service delivery solutions.

The third key focus area is how we engage and retain customers. We know that a 1% increase in Terminix customer retention produces a $10 million to $12 million increase in annual revenue. As I mentioned a moment ago, the use of the digital mobile platform gives leadership visibility into each and every customer interaction and should drive increased field technician engagement with our customers, which together, will improve customer retention. We are currently piloting new route technician pay plans that stress service, not production metrics, which will drive improved customer retention.

I'm pleased to share that leading customer retention indicators are improving at Terminix. Our analysis indicates that net promoter score, or NPS, is the most highly correlated leading indicator for pest and termite control customer retention, and our efforts to improve customer service are driving higher NPS. For example, our second quarter monthly pest control and termite NPS was significantly higher than prior year. Although we anticipate NPS to be variable on a month-to-month basis going forward, the trend is definitely in the right direction as we are trending up each month, and we should see an impact on customer retention as we move throughout the year.

In combination with these efforts, we are making additional sales and marketing investments to drive higher levels of customer acquisition.

I'll now review the performance of Terminix, American Home Shield and the Franchise Services Group. Turning to Slide 7 and the second quarter performance of Terminix. Revenue increased $14 million or 3% versus the prior year to $428 million as the increase in core termite control, termite renewals, wildlife exclusion, core pest control and mosquito sales was partially offset by the expected decline associated with Alterra, a company we acquired in November 2015. Adjusted EBITDA for the second quarter declined by $7 million from $112 million in 2016 to $105 million in 2017.

If you view the waterfall chart on the bottom of Slide 7 and starting on the left-hand side, you'll see that higher revenue conversion contributed about $8 million in the second quarter. Moving to the right, we incurred about $3 million in additional production labor costs, $2 million from having more route technicians and $1 million for more supervisors. This investment was made to improve safety, customer service and retention. We found that to meet our customer service expectations, at the outset of this effort that we need to allow for more time for service business but anticipate optimizing the process going forward, which should reduce the labor costs.

The $2 million increase in termite damage claims reflect increased warranty claims in the second quarter of 2017. The increase reflects timing associated with satisfaction of our obligations under termite protection plans. Because our best-in-class guarantee extends over a year, and longer when our customers renew, we normally will see variances from period to period. We currently anticipate that termite damage claims will be $1 million unfavorable in the third quarter versus prior year but $1 million favorable in the fourth quarter, or flat overall, in the second half of 2017.

The $1 million increase in our insurance programs was principally driven by an increase in the number of company-owned sales vehicles versus the prior year. The $1 million increase per quarter versus prior year should continue in the second half of the year.

The $4 million increase in sales and marketing costs was driven by $2 million of higher commissions, primarily attributable to growth in core termite, and $2 million of incremental marketing investment to drive growth. Please note that we are planning to spend about $10 million more in sales and marketing in the second half of 2017 versus prior year to continue to drive organic growth. The unfavorable $4 million shown in the other bucket includes legal settlements and other reserve adjustments and investments in sales and service mobility, partially offset by favorable fuel prices.

In summary, regarding the additional costs, we are investing in growth as we realize the benefits of new processes like multi-day planning. We should eventually see efficiencies that will improve margin. However, we believe that full year 2017 EBITDA margins will now be between 200 and 300 basis points lower than the prior year due to the increased investments to improve sales and service at Terminix.

Turning to Slide 8 and the Terminix revenue drivers for the second quarter. Termite revenue, including termite renewals, increased 5% versus prior year, while organic termite revenue also increased 5%. Starting on the left side of the chart, revenue from termite completions or new termite sales and other services of $93 million is an increase of $5 million or 6% over the prior year. Termite renewal revenue increased $4 million or 4% to $84 million. During the second quarter, about 75% of this $93 million in termite completion and other service revenue was derived from the sale of core termite completions needing a first-time termite service. Core termite revenue increased about 5% year-over-year, continuing the trend established in the fourth quarter of 2015 of year-over-year increases in the number of core termite completions.

The remainder of the $93 million of termite completion and other revenue comes from services such as exclusion and installation, and this revenue stream increased about 7% year-over-year. Termite renewal increased by 4% compared to the prior year, driven by price, a favorable change in the timing of service delivery and an initiative to upgrade our bait monitoring stations for a small subset of our customers.

Pest control revenue of $229 million in the second quarter increased by $3 million or 1% versus the prior year. As previously mentioned, organic pest control revenue growth was significantly impacted by an expected $5 million organic revenue decline associated with Alterra. Excluding Alterra, organic pest control growth was $5 million or 2%. Based on the traction we're getting in organic growth at Terminix, we are increasingly confident that we have taken the right steps to improve service quality, retention and growth and still expect organic growth at Terminix to range from 1% to 2% for the full year.

Let's turn to Slide 9 and discuss American Home Shield's second quarter performance. American Home Shield, or AHS, had a strong quarter with strong top line and bottom line growth versus the prior year. Revenue increased from $282 million to $326 million or 15%, with organic growth contributing slightly over half of that growth and acquisitions driving the remainder. The organic revenue growth was mostly driven by growth in customer count, which accounted for 7% of AHS' 8% organic growth. Higher prices accounted for 1% of the organic growth in AHS. The OneGuard and Landmark acquisitions contributed about $21 million or 7% of the growth.

Revenue growth was solid in both of our 2 key channels to market. Year-over-year, organic growth and direct-to-consumer channels was 7% and 8% in the real estate channel. We remain focused on sustaining our strong growth rates through optimizing our advertising, promotion and direct mail campaigns to drive new sales units as well as improving service quality to improve retention rates.

Second quarter gross margin was relatively flat versus prior year at approximately 50%. EBITDA increased year-over-year by $11 million or 15% and with flat margins at 25.3%. With that said, excluding the impact of acquisitions and prior year investment gains, the EBITDA margin improved by 130 basis points.

To understand the drivers of EBITDA growth, please turn your attention to the waterfall chart on the bottom of Slide 9. Starting on the left side, the largest contributor to the increase in EBITDA was $9 million of flow-through from organic volume growth. On a percentage basis, we had 8% of organic revenue growth comprised of 7% growth from volume and 1% growth from price increases.

Price net of inflation on claims costs provided an additional $2 million of the EBITDA benefit in the quarter as higher pricing more than offset normal inflationary pressure on the underlying costs of repairs. There were no major year-over-year variances related to claims incident rates or the mix of claims for replace versus repair. Acquisitions contributed about $5 million in the second quarter. On a year-to-date basis, the acquisition of OneGuard and Landmark have contributed $8 million of incremental EBITDA, and we expect these acquisitions to contribute another $4 million of EBITDA improvement in the second half of 2017.

A $2 million decrease in sales and marketing costs is advertising campaign timing related that the spend moved to the third quarter. We plan to increase our marketing spend by about $7 million in the second half of 2017 as compared to the prior year.

The $4 million increase in call center service costs was driven by higher labor costs resulting from both an overall increase in call center staffing levels to improve response times and staffing levels that were too low in the second quarter of 2016. Call center costs should be approximately $2 million higher in the second half of 2017 versus the prior year. And finally, we lapped prior year investment gains of $3 million that did not reoccur in the second quarter of 2017.

As we mentioned on the first quarter earnings call, the AHS team continues to upgrade their contractor base, both with respect to total capacity as well as quality. We manage over 15,000 contractors and believe this provides us with the necessary scale, competitive advantages and capacity to continue to grow going forward. In total, our contractor base as of the end of June 2017 was 7% higher than it was as of the end of June 2016, and our preferred contractor count improved by 9% during this time frame as well.

Regarding contractor quality, AHS is driving several initiatives to continuously upgrade contractor performance, which in turn, should drive higher customer retention. In the second quarter, the results continued to be impressive as every trade increased its overall contractor quality ratings versus the prior year.

Moving on to Slide 10, let's now cover the Franchise Services Group's second quarter performance. Revenue increased $2 million year-over-year or 5%. The increase was driven by higher domestic disaster restoration fees and janitorial national account revenue, offset in part by the 2016 Merry Maids branch dispositions impact of $2 million. Excluding the conversion of the Merry Maids branches to franchises, revenue was actually 8% higher year-over-year.

Adjusted EBITDA for the second quarter was $22 million, which is $3 million or 15% higher than the previous year. This improvement in EBITDA was driven primarily by ServiceMaster restore fees revenue related to extreme weather and other disaster events and higher franchise development license sales. The branch-to-franchise conversion for Merry Maids in 2016 had a negligible impact on adjusted EBITDA.

The Franchise Services Group improved EBITDA margin by 380 basis points in the second quarter versus prior year to 41.6%. In the first half of 2017, the Franchise Services Group EBITDA has grown 17% over the same period in 2016, thanks in large part to higher fee revenue arising from disasters in Canada and elsewhere. Although we cannot predict what may or may not occur with respect to natural disasters and other events in the rest of the year, we do expect a lower level of fee revenue in the second half of 2017.

Turning to the consolidated P&L, Slide 11, and looking at ServiceMaster in its entirety, the year-over-year revenue increased 8% or $60 million, including $38 million or 5 percentage points of net organic growth. The remaining $22 million of revenue increase comprises $3 million due to acquisitions within Terminix and $21 million from the acquisitions in AHS, partly offset by $2 million of revenue divested due to converting the Merry Maids branches to franchises.

Gross margins are slightly lower versus the prior year. The decline in Terminix margins driven by our investment in improving sales and service delivery more than offset higher margins in the Franchise Services Group.

The year-over-year SG&A increase of $19 million primarily reflects $4 million of Terminix sales and marketing costs, $7 million of costs from acquisitions in AHS, $4 million of call center service costs at AHS and $3 million of higher depreciation expense, primarily related to vehicles and the investment in technology to upgrade the mobile digital platform at Terminix. As a result, SG&A as a percentage of revenue increased by 50 basis points to 25.5%.

Net income of $85 million for the quarter is up $69 million. As a reminder, we had pretax charges of $88 million in the second quarter 2016 related to a Terminix fumigation matter and a $23 million insurance reserve adjustment. Adjusted net income for the second quarter is $93 million, which is flat with the same period in 2016.

Moving on to Slide 12, let me cover the bridge from adjusted EBITDA to adjusted net income to help explain how higher EBITDA in the second quarter 2017 translated to flat adjusted net income. As previously noted, adjusted EBITDA for the second quarter of 2017 was $210 million, which is $7 million or 3% higher than the same period in 2016. However, depreciation expense in the second quarter was $4 million higher than it was in the same period of 2016. Additionally, the effective tax rate in 2017 was higher. The increase in depreciation and the effective tax rate offset the year-over-year increase in adjusted EBITDA, resulting in essentially flat adjusted net income versus the prior year. The higher depreciation expense was driven by prior year investments in technology, as we've discussed in prior calls as well as from acquiring company vehicles for our Terminix outside sales professionals.

With respect to cash flow, on Slide 13. Free cash flow was $117 million in the quarter, which is $7 million or 6% lower than the same period in 2016. The decrease in cash flow was driven by the timing of interest and tax payments in the second quarter of 2017 versus the same period in 2016. We generated $117 million of free cash flow in the second quarter and $225 million year-to-date. For the 6 months ending June 30, 2017, the free cash flow was $225 million, $13 million or 6% better than the prior year. Free cash flow conversion to EBITDA was 66% for the 6 months ending June 30, 2017, versus 64% for the same period in the prior year.

In the second quarter, we used $34 million to buy back ServiceMaster common stock and paid down $32 million of debt, including $17 million for purchase and cancellation of a portion of our 7.25% 2038 bonds. Our overall cash balance has increased by $81 million since the end of 2016.

Regarding the $34 million of share repurchases made in the second quarter, 872,000 shares were acquired at an average price of $38.67 per share through June 30, 2017. We have reacquired approximately 3.9 million shares of common stock since we began the program at an average price of $37.59, which totals $145 million or 48% of the approved program to date. We currently have $155 million remaining from the original $300 million share buyback program.

Finally, moving to Slide 17. We are revising our full year outlook for 2017 as follows. We're raising our full year 2017 revenue expectations to a range from $2.9 billion to $2.92 billion or an increase of 6% compared to 2016, reflecting higher revenue growth than originally anticipated at Terminix and American Home Shield. Due primarily to increased investment in sales and services at Terminix, we are lowering our full year 2017 adjusted EBITDA expectations to a range from $675 million to $685 million or an increase of 1% to 3% compared to 2016. We are adjusting our EBITDA guidance downward to reflect the fact that it's requiring more investment in growth that originally anticipated to achieve higher levels of organic growth. For example, technician labor levels are higher than originally anticipated to achieve the level of service necessary to drive customer retention. Additionally, we have increased our spending on marketing to drive lead generation and increased our staffing of sales technicians to help spur new organic sales. Although these investments have a short-term impact on margin, we're confident that they will eventually generate strong organic growth. We also believe that the implementation of new operating processes and systems, like multi-day planning, will eventually create cost efficiencies to allow us to claw back margin erosion. Please note that our 2017 outlook excludes the impact of any potential acquisitions during the remainder of the year.

With that, I'd now turn the call back to Brian so we can move into the Q&A portion of the call. Brian?

Thanks, Tony. As a reminder, during the question-and-answer session, we encourage you to ask any questions that you may have, but please note that guidance is limited to the outlook we provided in our press release and webcast presentation. (Operator Instructions)

Carlos, let's open up the line for questions.

(Operator Instructions) We do have a question from the line of Toni Kaplan with Morgan Stanley.

It seems like some of your initiatives to try to drive growth in Terminix may already be starting to show some benefits on the top line. Can you discuss why you're increasing your investment again and just provide a little more color on where the investment dollars will be going. I know you mentioned marketing and sales would be about $10 million in the second half, but just some of the other areas and specifics that you're planning on spending on.

Okay. Thanks, Toni. Besides the $10 million of increased sales and marketing in the second half, also, it should be noted that our experience in the second quarter has shown that our technicians are spending more time on average on servicing work orders with our customers. And so we've increased technician labor as well. We also mentioned that our termite claims cost is trending higher, although in the second half of the year, that should be fairly flat, maybe a little bit more in the third quarter and a little bit less. I think those are the primary areas we're investing in. You really -- sales and marketing is probably the biggest impact in the second half in the aggregate. But our labor is going to be -- our technician labor, as I mentioned, is going to be a little bit higher based on experience that we're getting, mainly through better tools and processes and managing it through our multi-day planning process. We're just committed to making sure that service level is great, and that's where we're coming from on that.

Great. And then just a follow-up. Nik, I know it's very early days for you, but just wanted to get your sense of what you have found so far to be sort of what the execution issues have been that have been in the Terminix business recently and sort of what your approach will be to sort of tackle it.

Thank you, Toni. First of all, I wanted to start at the outset saying how excited I am to become part of the ServiceMaster Company and its strong brands with such impressive penetration across America. In the last couple of days, I have met with several people across the group, not just Terminix, American Home Shield and Franchise Services Group in the business. To your question, I see this more as execution issues and taking [routes.] I think the company completely understands where our problems are, where our issues are. We still have a long way to go in fixing some of the key fundamental issues that we can get to a consistent level. The culture I want to instill in the company is one of consistency and delivering on commitments. And to there, I think we definitely need to improve the granularity with which we follow some of our initiatives, how we track and monitor and continue to improvise on what we've already got in place, but even creating new ideas. Getting new technicians in place is one thing, but getting them to the same level of expectation that we need them to be to deliver a high level of -- not only from an outperformance perspective but also from a productive level, will -- takes its own time. So I think the company -- the Terminix business people are on the right track. There are going to be some initiatives we'll have to take in terms of making sure we have the right people in the right place, but I will be updating you as time goes by in a fairly short amount of time. But my first blush, I'm very encouraged. I'm also encouraged with the strength of the brand itself and how customers react in terms of the service levels we provide them.

Our next question comes from the line of Sam Eisner with Goldman Sachs.

So just going back to the guidance for the year, on the EBITDA guidance. I think at the midpoint of the prior range and the new range is about a $27 million delta. Can you walk through the various pieces of it? Obviously, you gave some information, $10 million higher in Terminix. You called out about $7 million of marketing spend in AHS. So is there a way to maybe break down all the pieces just so we know kind of at the midpoint what the variances are, the changes are, in that guidance at the midpoint?

Yes, Sam. I mean, the primary -- the 2 primary areas where we're really investing for growth are, number one, sales and marketing. And as I just mentioned, sales and marketing is going to be $10 million higher in the second half of the year versus the same period in the prior year. We think this is absolutely critical to continue to keep us on a path for growth. So that's probably the biggest bucket in the second half of the year as far as year-over-year investments in growth to sustain some of the progress we saw in the second quarter. The other -- the second area, again, is labor. As I mentioned on the call, last quarter, we added about $1 million, $1.2 million in service manager investment so we can reduce the span to control. And as we said, then that would continue. We did bring on technicians earlier this year than we have in the past. But what we're finding and what's changed in the -- what we're noticing in the second quarter is the actual time that each technician spends on performing out the service that we'd like them to perform is taking more time. So we've adjusted our labor costs upward for the rest of the year, and that's probably the second most significant area of increase. The termite damage claims are going to run higher this year in the aggregate, somewhere probably around $3 million to $4 million. And so that -- this is just one of these areas that is quite variable from year-to-year and even quarter-to-quarter. The business has grown over the years, and of course, termite claims are -- could grow a little bit with volume. But those are the primary areas that I'm seeing that are causing us to have the margin erosion be more of the 200 to 300 basis point range than the 100 basis point range that we commented on earlier. And we think these investments are absolutely critical. We're committed to organic growth. We're going to evaluate our progress in that regard continuously every day, and we're going to report on that every quarter and let you know how we're doing on that. But we're encouraged by the early returns we're seeing.

That's helpful. And then to the point about labor cost and spending more time at individual calls, I mean, I hesitate to ask the question, because I don't know if I'm going to get an answer, but how do we think about the long-term margin profile of the Terminix business? If you're commenting on the call that you're spending more time, the actual kind of volume might decrease or the cost per service is actually going up, are we -- are you signaling that the long-term margin potential of Terminix is not as strong as it once was and we should continue to expect kind of lower margins in that same range going forward? I guess how would you ultimately answer that question?

Yes, that's a good question. Our -- we're pretty excited about our multi-day planning in our -- which is routing and scheduling tool. We think that's going to eventually improve efficiency as well as the improvement in service level that we've already seen. So we expect over time to scale -- to claw back some of the margin erosion that you're seeing this year. We can't give any specific guidance on exactly how much, but I'm very confident we're going to see some level of cost efficiencies. Nik?

Well, what I'd like to add to that, Sam, here, is it's very, very important for us to ingrain that raising our service capabilities and delighting our customers to continue to have stronger engine and engagement of new customers coming in, so getting that growth rate, but we're not going to lift our pedal -- foot off the pedal on productivity. And I think these initiatives, the mobile digital platform, multi-day planning, improving the efficiency will definitely provide us the balance to ensure that we continue to generate higher margins as we go forward as well.

Our next question comes from the line of Andrew Wittmann with Robert W. Baird & Co.

Oh, great. I wanted to ask my first question on the sales and marketing spend increase. And I guess the question is, is the service model in place? Obviously, you've invested a lot in it, but a lot of these changes are new. Is the service model in place to service this to the standards that you need to service it at to deliver this increase in marketing spend? And also related to that sales and marketing spend, what date are you looking at that's showing that incremental spend is going to drive incremental returns and not diminishing returns?

So let me address the second question first, Andy. We constantly look at lead generation and tie that and correlate that to our advertising and promotion spend to make sure that we're getting a return on investments. And we -- as you know, in the -- we mentioned in the first quarter, we've invested a little bit more in some, I would say, TV and radio advertising. And so we're now assessing what that's actually doing for lead generation. And we'll continue to monitor that and other metrics to make sure we get our return on investment that we really would like to get. Could you -- now, could you articulate the first part of your question again to me, Andy? I'm sorry.

Yes. No, I mean, I just wanted to make sure that -- I mean, presumably, I mean, this is a very large increase in sales and marketing spend. I just want to make sure that you guys feel confident that the service model is in place to service this at your new higher levels of expectations. And if there's any color you could just give us that says the new people you've hired, the new technicians, sales managers, service managers that you've hired are ready for what could be a material uptick in growth.

Yes. What we're most encouraged about, Andy, and with -- and this metric has the highest correlation to customer retention. The net promoter score has increased significantly in the second quarter, and it's trending higher as we go. That to me is probably one of the most important metrics that shows that we are improving. I will say this, we still have some way to go to get to where we want it to be, to get it to the standard that we're pursuing. But we're pleased with the progress, but there's more to do. We'll continue to monitor NPS and total on-time delivery and other service metrics to make sure we drive towards excellence.

Given the -- just to fill in on that, obviously, this comes from a fairly limited view in the last few days. But I'm encouraged with the scores we have. I'm encouraged with the initiatives we're building on. But I think we're -- I still would like to get more knowledge about it, but I think we still have a long way to go in ensuring we can do this on a consistent deliverable basis. Clearly, we're heading in the right direction. I think we're putting our money as it needs to be put. We're putting the customer at the center of everything that we're doing. But to ensure that we can actually deliver that with strong productivity -- so there are initiatives to deliver productivity as well, but to do that both on a consistent basis is something we're going to work really hard on in the next coming months and weeks.

Great. I wanted to then switch over to the American Home Shield business for my follow-up question. And really, kind of a 2-part question here is, one, Nik, I think I'd like to get your initial thoughts on what you see in this business and the customer promise behind it. It's obviously a fairly unique business in the public market. And given that the spin is part of the future, I'd love to get some of your initial impressions about the quality of this business, the -- and the outlook for this business. And Tony, I just wanted to -- as you're looking at the business here, I just wanted to get your sense about what you think the right incremental margins are for this business longer term.

Nik?

Again, from a few meetings with the key people in the business and the people down the line here, I must say it's staffed with a group of high-quality individuals, very talented people. As you know, it's got close to over 2 million customers, which demonstrates a very, very strong penetration across the market. But what's more encouraging is that penetration continues to increase, as is evidenced by not only the quarterly results but what we've been sustaining. While it's not perfect in terms of service delivery, I find very encouraging that the customer escalation of complaints was driven down significantly lower over the last quarters, and it's at an extremely low level. So with 2 million customers, we get about 3.8 million service requests, as evidenced last year, and the percentage of customer complaints that get escalated is extremely low. What I like is the culture in that business, which takes these -- every single complaint so seriously and are attempting to further improve those as we go. So I must say, I think from a stand-alone perspective, I'm very confident, and I'm fully supportive of the board in terms of the timing. But the other thing I believe that, not only because of its strong history and penetration and what they're doing, but it has several avenues of potential growth going forward. And that's something -- apart from ensuring I provide leadership for Terminix, is going to be how I challenge American Home Shield to achieve its full potential and work on the new avenues of growth that are available to it, just given the kind of penetration and satisfaction we have with the customers.

So I'll take the question on incremental margins, Andy, and I'm actually glad you asked that question. I've been looking at that pretty closely since the first quarter call, and I can give you some more specific information on Q2. If you back out the acquisitions and just look at the organic EBITDA conversion, we're talking roughly 42% incremental margins in the second quarter and a little bit higher than that year-to-date. But I'd still say that if you look at it more on a full year basis, the 35% is about what we think it's going to be going forward. I think -- when I commented on this previously, I didn't really understand the full impact of -- the impact that these acquisitions had on the margins. And after looking at it in more detail, the 35% number is a good number to think about with respect to incremental margins going forward.

Our next question comes from the line of Anj Singh with Crédit Suisse.

First off, Tony, I was wondering if you can give us a sense of your comfort around whether these investments in Terminix are going to be enough to drive the growth that you're targeting. Realizing that these are critical investments, as you've stated, I was wondering if you can speak to the likelihood of another stepdown in margins as you look to sustainably grow this business. More explicitly, is the 21.5% EBITDA margin implied in your guidance for that segment, is that the right way to think about as a trough level?

All right. So first off, the first question, do I think the investments are the appropriate investments to drive growth ultimately? And the answer is yes. And I can say that because I see the underlying metrics are all improving that will drive higher retention. NPS and total on-time delivery and all the key things that we're looking at to manage and monitor service levels are having an impact. So I feel confident in that. As far as your question on going forward what to expect, I expect that our margins are going to stabilize in the guidance that we gave this year. And I do think over time, we'll claw back some of that as we get efficiency in things like multi-day planning and other areas of the business that we're going to look at in depth. So I'm encouraged with what I see there, and I'm encouraged, most importantly, on what all these investments have had, the impact it's having on the underlying metrics that we follow that will drive growth.

Okay, got it. And then for a follow-up on AHS. The organic growth in Home Warranty seems to be a little bit slower versus recent trends, at 6-ish percent. So is that just related to the loss of the financial institution customer you've referenced in previous quarters? Is there something else happening this quarter? And if you could give us an update on your latest thoughts with regard to the sustainable long-term growth algorithm for AHS, any changes there between what is the right way to think about pricing versus volumes?

The organic growth was actually 7% from volume, from customer account growth. And we think that the overall organic growth, including price, 8% to 10% is the range that we think of in this business, and we were about 8.5% when you throw price on top of the 7%. So we're comfortable, given what we're currently spending on our marketing investments, that we can sustain that going forward. The main reason is because we -- the market itself is underpenetrated, only 4 million homes out of the 71 million homes in the U.S. have a home warranty, and we're 4x bigger than the largest competitor in this segment. So we have a unique opportunity to sustain that level of growth going forward. So nothing's changed there. We still feel very confident in the long-term strategy there and achieving that level of growth.

Our next question comes from the line of Judah Sokel with JPMorgan.

First question is around Terminix organic growth. The second quarter clearly saw an encouraging step-up in the organic rate, particularly within pest control. That was a highly encouraging sign coming after 1Q's decline. So maybe you could help us think about why the reiteration of the full year guide. Is that just a function of maybe 3Q seeing tougher comps, particularly because of termite control? Or is there something else going on that caused 2Q to bump up so significantly that might go away in the back half?

Well, I think we're encouraged, first off, about what we're seeing in Q2. Definitely a turn in the organic growth for the pest control, and then with the continuation of pretty good growth rate with respect to termite completions. And we're -- as we look forward to what we need to do going forward to sustain growth and to further improve it, we realize that we have more work to do in improving our underlying processes. And so we're going to take it one quarter at a time, and we're going to basically evaluate what we're doing each quarter and what result we're having. I am sure we'll make further adjustments in some of the actions we're taking to improve organic growth, but we're really encouraged by what we see going forward.

The next question comes from the line of Gary Bisbee with RBC.

Nik, so a question for you. I guess can you give us just a little color on your background, including you mentioned having worked in some services or led some services-related businesses. And maybe an anecdote or 2 on why you think you're well positioned to lead the company forward here through the change that needs to happen.

Well, thanks for the question. If you've seen my background, you see I bring about 3 decades of leading large, complex and global organizations. And most of my time has been spent in transforming businesses either from turnaround situations or taking good businesses to great. My experience of -- the most recent experience I had in the years is doubling the size of the business in 7 years. And a lot of that came from adding the service aspect to what was a very parts-centric, OEM-centric business into the field of aftermarket and even taking it to a level where we really started serving not just the customer but the customer's customer. And this was a global approach where we learned how to sort of have -- it's very similar to the technician approach, and the ground -- field approach that we have with Terminix specifically, where we have to develop a large amount of workshops, drivers in the commercial vehicle field, which created a significant amount of brand loyalty and pull-through for the product. And obviously, from an aftermarket perspective, it also helped develop a lot of improved profitability for the -- for that business. Even from a regional business that I drove after that, the whole orchestration was, how do we not only satisfy our OEM customers, but how do we take it to the field? How do we develop a field of dedicated, loyal technicians, workshops, dealer networks and customer loyalty that pulls through our product? So it was a very B2C approach compared to the B2B approach that I picked the business with when I started 7 years before.

Great. And the follow-up. Tony, could you give us some sense on how the technicians at Terminix are responding to all the changes? It seems to me that's got to be a pretty big cultural change for them to go from efficiency, meaning how many stops a day they could deliver, to, hey, now we really want you to be focused on customer service, and for some of you, we're testing new comps that's focused on service rather than number of stops, et cetera. Is there -- are they behind this? Is there a group you're going to have to change out because they don't like the new approach? How are you managing that? I guess just any color to help us understand how that's going, outside of hiring, which you've already talked a lot about.

Yes, that's a great question. I mean, as you know, it's -- changing culture in a business of this size is a challenge. And it's a challenge we embrace, but it's one that we're on a journey right now with rolling out all of the things that we've done to improve service levels. And obviously, there are going to be some of our technicians that either don't want to or can't adapt to that, and that process is ongoing, and we're making -- we're bringing new people in, and some people are trading out. But I would say in the aggregate, I think it's being well embraced by the group. We still have a ways to go. We're not -- this journey is not complete by any sense of the word, but overall, I'm encouraged that it -- of how it's being received by the technician labor force. But there is going to be some fall-off for some that just don't fit into the new culture.

And for me, on that, it's a matter of instilling a culture that ensures consistency in outperforming markets and raising the bar on what our entitlement is, not just getting incremental growth, and ultimately focuses on delivering superior results. So having that culture not just at the leadership level but across the board. What I've seen in the last few days is a group of highly passionate individuals bringing their best work, but we've still got holes we need to fill. I think we -- I've seen a lot of areas where there is still more promise that we can build on. But by far, I see the fundamental infrastructure and the direction that it's taking is in the right direction.

Our next question comes from the line of [Will Naved] with JPMorgan.

Tony, perhaps this one for you. My question is related to the balance sheet. Firstly, the 2 companies, post-spin, what kind of financial leverage would you expect each company to support on a stand-alone basis? If you're not comfortable putting a number at this point in time, perhaps if you can comment on whether each of these stand-alone companies can support higher or lower leverage versus the consolidated company today.

Yes, sure. Now look, we -- there's a lot of details that we have to work through on the spin, and we don't -- we're not going to release anything at this point as far as the targeted leverage ratios for each of the individual companies. I will say this; both companies have strong cash flow, and that gives us a lot of options. But we're going to go through this methodically and come up with the right capital structure for both companies. And in due time, that will be disclosed.

Would you be able to share whether or not the current balance sheet's [banking] bonds would be refinanced post spin? Or would they stay in place?

Again, we're not going to go through any of those details. It's just premature to get into any of that right now with -- and we'll be back in due time with all that information when it's the right time to do it.

The next question comes from the line of Dan Dolev with Nomura Instinet.

Congrats on the new role. Have you ever -- as part of your plan, have you actually thought about how many technicians you would need to add? Have you ever quantified the number of technicians that you would need to add to get to a steady state?

First of all, I want to thank you, Dan, for your wishes. I'm not going to stand here in 3 days and tell you exact numbers and stuff, but I'm -- look, I've gotten a great feel for it. I'm looking into it. I think we're investing in the right places. I think we're investing in the right kind of people, and we're investing in the right kind of processes and systems to aid that. We will continue down this path to not only improve our growth profile but also challenge the business to think about what our real entitlement as a company is. We have a strong brand, which should allow us to continue to build on its strength, and I think we're taking the right steps in the direction. I think it would be a bit premature on my part to give an exact number of what number of technicians and all we should have. But you will see me coming with very transparent stories as we keep going forward, as I keep getting intimately familiar with my businesses and getting my hands and legs deep into the business.

And do you expect to -- second question, do you expect to maybe make any management changes within Terminix now? Or is it kind of where we are is sort of the right sort of management team?

Well, I can't say we will be where we are, given the limited exposure. But definitely, my goal is to provide -- personally, provide leadership to Terminix. That's one of the highest priorities apart from executing a flawless spin and positioning both these companies, not just with Terminix but ensuring that I position both these companies with the best talent that they deserve and they can have for succeeding as independent companies. So obviously, the focus will be a lot on the internal candidates, ensuring there are the right people in the right place. But we are not going to be bashful of bringing in talent from outside, from benchmark companies or competition or wherever it might be, which is best suited for us to drive these -- the destinies of these businesses forward.

And we have no further questions on the phone lines. I'll turn it back to you, sir.

I would like to turn your attention to Slide 16 in closing. Our strategic focus will be to gain sustainable traction at Terminix and continue to build on the successes at AHS and FSG to deliver superior results. One of my primary goals is to drive a culture that consistently delivers on the commitments that we make. On the strength of our very strong market penetration and brand identity, we will continue to identify and pursue new opportunities for growth.

A key component of our effort is to unlock shareholder value, to efficiently execute the spin-off of AHS into an independent entity while developing the right talent for both companies to succeed in the future. Our overarching goal is to flawlessly execute on these initiatives to enhance shareholder value.

I want to thank all of you for joining our call today, and we look forward to reporting on our continued progress on the next earnings call.

Thanks, Nik. I just want to respond to one question, Anj from Crédit Suisse. I misunderstood your question and gave you a wrong answer. Organic growth for AHS in the second quarter was 8%. It was 7% for direct-to-consumer and 8% for real estate, or 8% overall. So I apologize for that, for misspeaking.

So thank you again for your participation in today's conference call and webcast. As a reminder, a replay of the call will be available on our website at www.servicemaster.com in about one hour from now.

We look forward to speaking to you again on our third quarter 2017 earnings call at a date to be announced in October. Thank you, and goodbye.

Ladies and gentlemen, that concludes today's call. We thank you for your participation and ask you to please disconnect your lines.